TNN | Oct 20, 2014, 07.08AM IST
You are a diligent saver, a careful investor and a meticulous planner. Yet, you have not been able to build wealth even as everyone around you seems to be wallowing in money. What’s stopping you from getting rich? If you really want to get to the root of the problem, you need to assess where you are going wrong in your investments. It could be the lure of penny stocks or the tantalising potential of the futures and options segment. Small investors often lose their shirts (and nearly everything else) when they enter these high-risk arenas.
But mistakes can happen even if you play ultra safe. If a fixed deposit offers 9%, the posttax returns for someone in the 30% tax bracket will be barely 6.3%. That’s not too bad until you factor in 8% inflation. So even though the investor does not feel it, his money is losing value. here are a few common hurdles that prevent investors from getting rich.
Trapped by value and price in stocks
Buy low and sell high is the ultimate winning strategy in the stock market. But some investors take this literally and buy very low-priced stocks. Since the market cap is low, these penny stocks are easily manipulated by operators who lure unsuspecting investors and dump worthless shares on them. They first create a buzz around a stock, indulge in circular trading to push up the price, and then nudge investors to buy at high prices. A penny stock is never a good investment, because you are buying it only in the hope of ‘finding a bigger fool’ who will buy it at a higher price. If a share is priced low, it is because the market does not see value. Study the fundamentals of the company. That will give you enough reasons to avoid the junk shares.
Buying overvalued stocks
One can go wrong even with the blue chips. Small investors often get carried away by the market euphoria ignoring the ‘value’ of the stock. A good stock at a very high price is not a good investment. This overvaluation can happen even at the broader market levels. We studied the Sensex PE and its returns over the past 20 years and found that when the market was overvalued, the one-year average returns were very poor (see graphic). Pay attention to valuation when you buy a stock. Even if the company is growing very fast, avoid investing in it if the stock—or the market—is overvalued.
Falling into value traps
Buying a stock just because the price has fallen 50% from its peak is not always a good proposition. You may end up in a value trap. Investors who go hunting for bargains in the initial phase of a bear market also get into the value trap. They compare the current price and PE multiples with the earlier peak and start buying because the stock is available ‘at a discount’.
However, the price may continue to fall and losses could mount. Most all-time peaks are scaled during extreme euphoria in the market and, therefore, do not represent the real value of that stock. Similarly, it is not fair to judge the current valuation of a stock by comparing it with its all-time high valuations. Instead, compare the current valuation with average valuations for the past 5-10 years.
Buying risky futures & options
Be greedy when they are fearful is what stock gurus advise. But some investors are greedier than they can afford to be. They get into the high-risk arena of futures and options (F&O) even though they don’t have the financial muscle or the acumen. The F&O segment allows an individual to buy up to five times the margin kept with the brokers. This means that with a margin of Rs 50,000, one can take a position in shares worth Rs 2.5 lakh. But while your gains can be five times greater, so can your losses. Whether it is the F&O market or the cash segment, don’t bite off more than you can chew.
F&Os are meant for hedging and retail investors should get in there only for hedging their existing portfolio. They can get into the speculative part later, but only after learning enough about the F&O market and the risks involved.
Overinvesting in safe options
Most investment portfolios are skewed in favour of debt. Investors want stable returns, even if they are low. But this ‘safety first’ attitude can hamper long-term goals because the returns from debt instruments lag inflation.
Even investors who are careful about their asset allocation can get it wrong. Very few salaried professionals take into account their Provident Fund (PF) when drawing up an asset allocation plan. The 12% of their basic pay that flows into the PF every month and a matching contribution from their employer is actually enough to take care of the debt portion of their portfolio. The rest of their investible surplus can flow into equities and other lucrative investment classes.
Not exploring other options
Bank deposits and Post Office schemes are the favourite investment options when it comes to debt. But these are not very tax efficient. The entire income from fixed deposits is taxable at the normal rate. For a person in the 30% tax bracket, the post-tax returns from a fixed deposit that offers 9% is actually 6.3%. Given the prevailing inflation rate, the investor is actually losing money. Factor in the post-tax yield when evaluating an instrument. Go for tax-free options like PPF or tax-free bonds. For salaried taxpayers, the Voluntary Provident Fund is a tax-free haven with no limits on investment.
Though the recent budget has reduced the tax advantage for debt mutual funds, FMPs still score better than FDs if the tenure is more than three years.
Choose consistency over great returns
Investing in the stock markets can be tricky. Even when you invest through a mutual fund, the timing of your entry into the market has a huge bearing on the return. Suppose you receive Rs 2 lakh as bonus from your employer, the stock markets are on an upswing, and you decide to park the entire sum in a high-performance equity fund. Subsequently, some bad news emerges that brings down the market by 40% over just a few weeks. Your fund also takes a hit, leaving you poorer by Rs 80,000. Here, the choice of fund was not at fault, nor was your decision to invest in the stock market. You should stagger your investment over a period of time. This way, you take a hit only on the initial investments. As the market begins to revive, you can invest the remaining sum. This will yield a healthy return on the overall investment once the market regains its previous level. SIPs, therefore, are a better option than a lump-sum investment.
Ignoring fund expenses
People may drive a hard bargain when buying fruits and vegetables but ignore the expense ratios of their mutual fund investments. The expense ratio of equity funds typically ranges between 2.5% and 3%. Over the long term, even a small difference in cost can make a considerable difference to your returns (see graphic). Check the fund expenses before you invest. There are enough good quality funds with low expense ratios. Another option is to buy direct plans that charge a lower expense ratio.
Life cover is not an investment
Chosen well, a life insurance policy can protect the financial future of the entire family. But, if bought for the wrong reasons, the same policy can become a drain on resources and prevent the policyholder from meeting crucial financial goals. These wrong reasons include tax savings under Section 80C, investment for retirement and gifts for children. Traditional plans are the biggest culprits, combining low life cover with poor returns. The life cover offered is 10-20 times the annual premium while the returns are at best 6-7% (see graphic). Yet, life insurance is a favoured investment option because investors see triple benefits: tax savings, long-term savings and life insurance. Since the premiums of endowment policies and money-back plans are very high, buyers are not able to take a very high cover. For instance, a life cover of Rs 1 crore for 30 years would cost a 30-year-old roughly Rs 20,000 a month if he buys a traditional insurance plan. But, if he buys a term plan, the same cover would cost him about Rs 1,000 a month. Traditional insurance plans suit ultra-highnet worth investors who are looking for tax-free income under Section 10(10d). Small investors should not combine insurance and investment.
Instead, a combination of a term plan and Public Provident Fund works better than an insurance policy. If you have a higher risk appetite, you could invest the savings on the premium in mutual funds which have the potential to give higher returns—though they carry some level of risk.
Source : http://goo.gl/tOB17m